Global financial conditions have improved significantly since the previous Financial Stability Review, despite the new uncertainty created by
the proposed sovereign bailout for Cyprus in the past few weeks. Some earlier
European policy initiatives had been seen as demonstrating a strong commitment
to deal with the region's sovereign debt and banking sector problems while
maintaining the monetary union, and this boosted confidence over much of the
past six months. Confidence was also enhanced by further signs of recovery
in some of the major economies, notably the United States, supported by continued
monetary stimulus. The improvement in global financial market sentiment has
contributed to a rally in risk assets across a range of markets, consistent
with increased risk appetite.

The improvement in market confidence has helped ease sovereign financing pressures
for a number of euro area countries that had been subject to the
greatest concerns about debt sustainability. Given the links between sovereign
and bank balance sheets, this had positive spillovers to bank funding markets
in the region. The euro area nonetheless still faces significant challenges
to its stability. Many banks, particularly in the periphery, are still experiencing
elevated funding costs, deteriorating asset performance and weak profitability
amid subdued economic and property market conditions. This has contributed
to tight credit conditions in the region as banks continue to deleverage and
reduce their balance sheet risks.

Given the unresolved vulnerabilities, it is too early to say whether the improved
market sentiment over the past six months is the beginning of a sustained
recovery, or merely a temporary upswing. Much will depend on the European authorities'
ability to implement the policy actions needed to restore confidence in debt
sustainability and repair banking sectors, while also fostering a recovery
in economic activity. In this context, the renewed market tension associated
with the handling of the sovereign and banking crisis in Cyprus in recent weeks
has provided a reminder of the political, economic and social challenges of
resolving the pervasive fiscal and banking sector problems.

Outside the euro area, confidence in the major banking systems has also generally
improved from six months ago, as evidenced by strong gains in bank share prices
that have often exceeded the rise in broader share market indices. Even so,
these banking systems are still at varying stages of their recoveries from
the global financial crisis; subdued profitability and elevated non-performing
loan ratios associated with slow economic activity and property markets continue
to feature in many banking systems. Issues around loan forbearance and banks'
asset valuations are also areas of concern in some countries.

Elsewhere, in countries that have been more resilient to the crisis, such as many
in Asia, banking systems remain in a relatively strong position. Some of these
countries, however, are beginning to confront a different set of challenges
associated with property market and credit expansions. It is normal for the
effects of low interest rates to be evident in asset prices and credit before
they can be seen in economic growth and inflation, and hence a prolonged period
of low rates can result in a build-up of credit risk long before inflation
starts to rise. In some countries, particularly those with limited exchange
rate flexibility and strong capital inflows, the authorities have sought to
contain these risks through macroprudential measures. These policy measures
have had to be progressively tightened in a few cases in response to continuing
credit and property market exuberance, illustrating some of the challenges
involved in calibrating and targeting these policies.

The Australian banking system also remains in a relatively strong position. The improvement
in global market sentiment since the middle of 2012 has, at the margin, eased
wholesale funding costs for the large Australian banks, with bank bond spreads
declining to around their lowest levels since the start of the crisis. The
banks have been continuing to limit their use of wholesale funding in any case,
and deposit growth has been outpacing growth in credit. Continued strong competition
for deposits has seen spreads on retail deposits remain around historically
high levels even as spreads on long-term wholesale debt have narrowed significantly
over recent months.

The banks have collectively continued to record strong profits in recent periods,
helping them to strengthen their capital positions further and putting them
in a good position to meet the Basel III capital requirements that began to
be introduced in Australia this year. The banking sector's asset performance
has also been improving, though at a gradual pace due to the challenging conditions
being experienced in some parts of the Australian and UK business sectors.
With domestic demand for credit likely to remain moderate in coming years,
banks are increasingly pursuing other strategies to underpin their profit growth
over the medium term, such as efficiency improvements and expansion in the
Asian region. While this remains an area to watch, there is little sign at
this stage that banks have been motivated to take on excessive risk or strain
their risk management capabilities.

Profitability in the general insurance industry was strong in the past year and the
industry remains well capitalised. Underwriting results improved in a more
benign claims environment following the sequence of catastrophe-related claims
events in 2011. The natural disasters in Australia early this year are not
expected to have a major financial effect on insurers.

A period of balance sheet consolidation has helped mitigate potential risks to financial
stability emanating from the non-financial sectors in Australia. Even though
the economy has been expanding at around trend rates, some firms have been
facing challenges from the high exchange rate and a return to more traditional
saving and borrowing behaviour by households. Consequently, business failure
rates have been above average, which has contributed to the slow pace of recovery
in banks' non-performing business loans over recent years; that said, the
vast majority of firms are still meeting their debt commitments. Overall, gearing
ratios are low and deleveraging is continuing in some parts of the business
sector, which is helping to limit the effects of subdued activity and profitability
in some industries.

Households' net wealth has been rising recently due to the recovery in housing
and other asset markets as well as continued higher saving and borrowing restraint.
Many households still prefer to repay existing debt rather than take on new
debt, which has contributed to the slower pace of household credit growth and
an increase in mortgage prepayment buffers. Debt-servicing capacity has also
been boosted by lower interest rates. Despite the unemployment rate having
drifted up a bit over the past year, housing loan arrears and other aggregate
measures of financial stress in the household sector remain low. Household
indebtedness and gearing are nonetheless still at historically high levels,
and hence continuation of the household sector's more prudent approach
to borrowing would assist in strengthening the sector's financial resilience.

After the fast pace of international regulatory reforms in the past few years, there
has been more focus recently on implementation of the agreed reforms at the
national level (particularly the Basel III capital standards) and monitoring
the consistency of implementation internationally through various assessments
and peer reviews. In Australia, the Australian Prudential Regulation Authority
(APRA) finalised its implementation of the Basel III capital framework, which
it began phasing in from the beginning of this year. APRA will shortly resume
consultation on the Australian implementation of the Basel III liquidity reforms
after a number of changes were made to the international standard earlier this
year. Legislation was recently passed that will help Australia meet its G20
commitment to move toward greater central clearing and reporting of over-the-counter
derivatives transactions. The members of the Council of Financial Regulators
(CFR) have been continuing their work on strengthening Australia's financial
sector crisis resolution arrangements, building on international best practice,
with a particular focus recently on financial market infrastructures.

At the international level, policy development work has been progressing on a number
of fronts, including addressing the risks posed by systemically important financial
institutions and strengthening the oversight of shadow banking systems. As
foreshadowed in the previous Review, the International Monetary Fund released its Financial Sector
Assessment Program report on Australia in late 2012, which contained a positive
overall assessment of financial system stability and supervisory standards
in Australia. This report made a number of recommendations that are being considered
by the relevant CFR agencies.